Russia’s Descent into Reality

The summer of 2007 was a busy year for the Russian oil and gas business.  In April of that year, the state-run energy company Gazprom finally exerted enough pressure on the Sakhalin II consortium to wrest control of the giant project in Russia’s Far East from Shell, who had hitherto been the majority owner and manager of the development.  In return for a cash payment of $7.45bn, at the time seen as a knock-down price, Gazprom acquired a 50% plus one share stake in the project.  The deal was struck after months of the Russian environmental regulator exerting pressure on the consortium Sakhalin Energy, resulting in work being delayed, stopped, and threats being made to withdraw the license to continue the development altogether.  Despite there being genuine concerns regarding environmental damage incurred by the development, not to mention the doubling of project costs to $22bn, few believed that the governmental pressure exerted on Sakhalin Energy was anything other than a naked attempt by the Russian government to gain control over the project, its resources, and its revenues by force.  Sure enough, within weeks of Gazprom taking the keys to Sakhalin II, the environmental regulator cheerily announced that all concerns had been resolved to its satisfaction and not a peep has been heard from them since.  The outcome at Sakhalin II was presented by the Russian government, and accepted by many Russians, as a significant victory of the resurgent Russian state in reversing the exploitations of the foreign powers when they were weak, and regaining control over Russia’s strategic resources, its wealth, and its independence.

Buoyed with confidence from their coup on Sakhalin, the month of June saw the Kremlin use alleged breaches of license obligations to persuade BP to sell its 62.85% stake in Siberia’s Kovykta development to Gazprom for $900m in cash, a figure many people thought better than what was feared, i.e. nothing.  Two months later, in August 2007, the Russian government moved to deny the Exxon-led Sakhalin I consortium the right to export gas from its development in an attempt to force the sale of the gas to Gazprom at artificially low domestic prices, after which Gazprom would be free to export it via pipeline or LNG carrier at international prices.

Now that Russia’s foreign-run developments were back under government control or suitably compliant, the government ensured that all future developments would remain similarly tied to the Kremlin with limited foreign influence.  In April 2008, the Russian parliament approved a new law which effectively handed monopoly rights for all future developments of the Russian continental shelf to just two companies: Gazprom and state-owned Rosneft.  By now, the bulk of Russia’s enormous hydrocarbon wealth both present and future was firmly in government hands, a situation which was looked on with gleeful satisfaction by Russians and allowed them to wield considerable influence beyond their borders.  Soon followed grand plans for Gazprom to build a pipeline across the Sahara desert, buy all of Libya’s gas, and build LNG plants in Nigeria.  Energy nationalism at home and the loudly announced forays abroad as personified by Vladimir Putin helped ensure the Russian population returned approval ratings of over 80% for their then president, now prime minister.  Russia had picked itself up off its knees, Russia was strong once more, Russia could once again command respect from others.  Russia was back.

But anyone who was looking closely could see that beyond the grand announcements emanating weekly from the Kremlin, Russia’s oil and gas development strategy was thin on substance and looking more than a little unrealistic.  The first warning came in April 2008 when Rosneft’s chief executive stated that Russia would need $2.6 trillion to develop just its offshore oil and gas reserves between then and 2050, which equated to a yearly expenditure of $62bn.  To put this in perspective, the Sakhalin II project – one of the biggest  and most complicated oil and gas projects every attempted and by far the largest in Russia – came in around $22bn and during the peak of construction was costing about $4bn per year.  This means that the Russian oil and gas development plans would see the equivalent of about 15 Sakhalin II sized megaprojects running in parallel across Russia for 40 years, executed and managed by just two companies – Gazprom and Rosneft – neither of whom have ever executed a project of such magnitude and complexity before.  Even a casual observer would think the numbers to be slightly overambitious, and overly reliant on the performance of two companies with an untested track record of project delivery.

Consider the news which appeared in the oil and gas press in June 2008 that Gazprom had stumbled at the first hurdle along its path to becoming the pioneer of Russian oil and gas development: a relatively simple topside refurbishment of a second-hand platform, part of the first stage of Gazprom’s much publicised flagship Shtokman project, was overdue with the budget blown due to the contractor not having enough skilled workers to complete the assignment.

Those with an interest in such matters may also have taken note of the enormous debts that the Kremlin’s favoured sons had accumulated.  By March 2008, Gazprom had accumulated $41.7bn in debt mostly due to acquisitions, and it is estimated that its current debt stands at about $50bn.  Rosneft was not in much better shape having amassed debts of $23.8bn, also largely on acquisitions not least of which was the remains of bankrupt oil form Yuzkos, flogged off the year before in a murky auction.  Concerns about Gazprom and Rosneft debts were dismissed by those who would point to the oil price which at the time sat above $140 per barrel generating massive revenues for the two companies, and the fabled wealth of the Russian government in terms of their foreign reserves and the oil stabilisation fund.  However, such responses could not hide the fact that both companies were heavily dependent on the western financial institutions to whom they owed the debt, and would rely on these same institutions to provide the funding for future developments.  It was also becoming more and more difficult to ignore the increased risk premium being attached to loans extended to Russian companies as a result of the government’s contempt for contract law and the unpredictability such behaviour brings.

Unfortunately for the Russians, by the end of 2008 their lofty position was soon beginning to look less secure than it had been six months previously, and by 2009 it was clear that their position was looking precarious.  With the global financial crisis setting in, demand for oil and gas collapsed sending the crude price tumbling by over 70% and taking the Russian energy giants’ revenues with it.  And the western financial institutions upon which they depended for debt refinancing and financing their lofty development plans were facing either complete ruin or a desperate struggle to survive.  The two companies upon which all the Kremlin’s hopes and dreams depended found themselves with diminished revenues and unserviceable debt going cap in hand to Moscow for a bailout.

Unsurprisingly given Russia’s dependence on oil and gas, the collapse in the oil price was matched by a collapse in both the rouble and Russia’s stock market.  Gazprom and Rosneft stock plummeted as the market fell by 75%.  The Russian government, which just months before had harboured deluded dreams of the rouble being adopted as a reserve currency, watched as it fell from a high of 23.1/$ and raided their foreign reserves at a rate of $15bn per week buying roubles in a desperate attempt to keep their currency from collapsing.  At the time of writing the rouble has depreciated to 36.2/$ (-36%) and continues to fall; Russia’s foreign reserves stand at $388bn down from $600bn in August, a reduction of 35%.

The Stabilisation Fund, designed to balance the federal budget when oil falls below a certain price, was established in 2004 and thanks to booming oil prices had reached $157bn by January 2008.  However, most of the fund was invested abroad and it is doubtful that the investments have avoided the carnage brought about by the financial crisis.  Worse, in May 2007 Putin called for more of Russia’s oil revenues to be invested in the Russian stock market, including Gazprom and Rosneft.  This means that part of the money being set aside for when the oil price falls was being invested in oil and gas companies, whose very fortunes are dependent on the oil price.  Speculation abounds as to the whereabouts and value of the money allocated to the Stabilisation Fund, and Russians are not hopeful that they will see any of it any time soon.

In response to the crisis the Russian government acted in characteristic fashion: by playing a strong hand very badly.  Eager to demonstrate its reliability as a supplier of energy to Europe, Russia entered its annual gas dispute with Ukraine in no mood to compromise culminating in their shutting off the gas flows leaving European customers shivering in the homes during a cold snap.  European Union monitors were somewhat unimpressed at having to provide hard-copy papers of their proposed activities to the Russians in advance of their being allowed to work, and the presence of shady third-party intermediary companies based in Switzerland in place of presented written contracts probably did little to reassure Europeans that their energy supplies were in good hands.  Despite Ukraine sharing a large part of the blame for the dispute, Russia came away with its reputation as being a reliable energy partner shakier than ever, looking incapable of handling business matters without resorting to fiery ultimatums and brinkmanship, and with a $1.1bn hole in Gazprom’s revenues.

Seeing its financial position take a sharp turn for the worst, Gazprom is looking to cut costs.  Having gleefully helped itself to 50% of the Sakhalin II project, it has now found itself required to stump up 50% of the operating costs.  Year-round oil export from the project started in December 2008 but coincided with the lowest oil price in several years, reducing the project’s revenues considerably.  First export of LNG to customers in Korea and Japan is likely to take place in early March 2009, but some of the gas was paid for in advance and thus Sakhalin Energy will not see revenues immediately.  Faced with the unexpected obligation of paying for businesses that it owns, Gazprom has ordered $300m cuts in operating costs from the development in 2009 and all non-essential projects, such as the third LNG train, have been cancelled.  Both expatriate and Russian staff are finding their terms and conditions being squeezed, and many are facing redundancy within the next few weeks and months.  Departments vital to the safe and efficient operation of the project facilities are being told to look again at their organisation and come up with ways to cut costs, which normally means do the job with fewer people.  The Russians who were overjoyed by the new, assertive Russia when Gazprom gained control of the project are now glumly looking at what this means in practice: unpaid overtime, reduced wages, and unemployment.  The expatriates are rolling their eyes wondering why turkeys vote for Christmas.  Whether Gazprom are rueing their decision to effectively stop Shell from paying for the Sakhalin II project (something they seemed quite happy to do until Gazprom showed up) can only be guessed at.  And Sakhalin Energy’s ability to run the extremely complex offshore platforms and LNG facility – which require an uptime of 98.5% – safely and efficiently with Gazprom (whose operational experience is limited to running onshore pipelines) calling the shots is a test which will be watched with great interest by those who have worked on the project since its inception and are now being given the boot by a Gazprom HR director parachuted in from Moscow.

If that was not enough to make those employed on Sakhalin Island gloomy about their employment prospects, Exxon have called a halt to the Odoptu field development, which was currently under construction as part of the Sakhalin I expansion.  The reason behind this decision to demobilise the construction team leaving a facility unbuilt are neither clear nor public, but it is widely believed that the Russian government was attempting to strong-arm the consortium into accepting conditions not agreed to in the original contract.  Exxon has an impressive record of not allowing itself to be pushed around, and probably calculated that the Russian government needs the revenues from the project more than Exxon does.  What effect this will have on the rest of the Sakhalin I project remains to be seen.

In other areas of Russia, the Shtokman project is looking to be put onto the backburner as Gazprom officials say that the project can only proceed with oil prices between $50-$60 per barrel.  Production in Russia is falling as the western Siberian fields go into decline with too few new projects coming online to replace them.  Employment in Russia is spiralling as the economy, so dependent on the export of industrial commodities, goes into rapid decline.  Anti-government protests are starting to appear in major Russian cities as opinion polls see Putin and Medvedev’s popularity waning.  Without the injection of foreign capital into developing their reserves Russia’s grand vision as being a global energy provider look to remain as mere dreams unrealised.  Perhaps surprisingly, the cash rich western oil companies still have an appetite for investment in Russia, and several are showing an interest in partnering Gazprom in the giant Yamal development in Arctic Siberia.  Without a doubt they will be far more careful the second (and for some the third) time around and we can expect to see guarantees in the form of internationally held bonds and cost-reimbursable contracts to be commonplace if such partnerships go ahead.

But having spent the past three years assuring its population that Russia is back to being a strong, independent country which does not need to partner with foreigners (a refrain which shows no sign of abating), how is the Russian government going to explain itself if it is once again signing “unfavourable” deals with western oil giants from a position of weakness?  Or will Putin and co. simply allow the Russian oil and gas industry to fall into inefficiency, stagnation, and mismanagement and blame everything on the west rather than admit that the policies they have pursued over the past few years have led them to disaster?  We will find out soon enough.

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